CORRUPTION AND THE SHADOW ECONOMY: COMPLEMENT OR SUBSTITUTE? EVIDENCE ACROSS INCOME GROUPS

Abstract

The paper explores the relationship between corruption and the shadow economy in high-income and low-income countries. Shadow economy refers to legal economic activity that is deliberately concealed from the government to evade taxes and regulations. The study examines whether shadow economy and corruption are complements or substitutes. To overcome the limitations of previous cross-sectional studies, a balanced panel of 98 countries (2010-2020) is employed, country Fixed Effects estimation is used, and standard errors are derived from the Driscoll-Kraay method. A composite governance index is constructed using Principal Component Analysis to deal with multicollinearity. The results show that corruption and shadow economy are complements in low-income countries, meaning that enhanced corruption control lowers activity in the shadow economy in these countries. In high-income countries, this relationship is not statistically significant: in these nations, control of corruption becomes part of the general institutional quality, without having a unique and independent impact on the informal sector.